In October 2008, economic news became very interesting. Within only a week or two, multiple major banks neared collapse, and governments around the world pumped billions into the economic systems. It was a near miss, and the world economy staggered for more than a year afterwards.
Of course, the US was where it all began, and where some of the problems were first felt. The Fed responded quickly and deftly by lowering interest rates and making several aggressive moves to save struggling banks. The federal government also responded with easily more than $1 trillion in various stimulus programs.
Since then, the situation has stabilized and there is even established data to prove the existence of an economic recovery. The question now is whether it can be a sustained recovery or if the economy might stall again—a double-dip recession.
This might turn out to be an even more perilous road than October 2008. Ben Bernanke, the chairman of the Fed recognized this reality even as he made the original intervention. Having expanded its balance sheet more than at any other time in history, the Fed now has to figure out how to pull out again. In effect, the decisions of the past have placed in the Fed on a knife edge between two extremes. Pull out too quickly and the economy might spiral into deflation with one of the deepest recessions the country has ever experienced. Pull out too slowly, and we face extreme inflation—again, probably of the greatest magnitude and duration yet.
This isn’t the first time that any of this happened. Americans will always be conscious of the Great Depression—the greatest test of our economic system to date. Then just as now, the government responded immediately and very aggressively with lots of liquidity and various efforts to stimulate the economy. Combined with the economic pressures of World War II and plenty of time, something happened to push the economy back into production, but not without a cost. The economic policymakers of that time failed to mop up the extra liquidity from their stimulus plans, and the next few decades showed it. The US suffered multiple decades of slow or negative growth with high inflation—stagflation as it came to be called. It wasn’t until the 80’s that the American economy enjoyed steady growth with minimal rates of inflation and not until the internet boom that really good times returned.
More extended hard times happened in Japan. After World War II, the US undertook a democratization of Japan that spurred a boom of capitalistic entrepreneurship. After an extended period of rapid growth, the government overextended itself and the economy overheated. The Japanese central bank held interest rates at a minimum level for more than a decade in order to spur growth. At that point, however, the damage had been done, and it was really too late to get the Japanese economy moving again. Economic historians refer to it as the lost decade or decades. Once again, this period was filled with stagflation—high inflation with little growth.
So what about now? Will the Fed walk the economy down the challenging road ahead without falling to either of the evils that could befall us? Hypothetically, it could be possible to finely balance economic factors and avoid both dangers. Furthermore, the economists at the head of the major fiscal policy makers are some of the best minds in the business.
However, democracies are a lot more complicated than an economist’s thought experiments. Sometimes the best policies cannot be effected because they simply lack political traction. Even more crucial is the problem of risk (a concept that everyone was reminded of in the global crisis). The negative consequences of a deflationary spiral are potentially much more dire than the possibility of an inflationary spike. Therefore, the Fed is more likely to err on the side of inflation in order to steer clear of the danger.
All in all, this probably means that the housing crisis and the catastrophe it produced could follow a general story line that recapitulates the decades after 1929. In this scenario, too much liquidity in the system would result in massive inflation or more seriously, long-term stagflation that lasts a decade or more. Based on the relative amount of liquidity that the Fed injected, this inflation could be huge. In fact, some conservative economists have referred to the coming period as “the Great Inflation.”
On the other hand, it is interesting that the process has moved much more quickly this time. In the 30’s, the problems were much deeper and took much longer. In fact, the process of falling into the Great Depression took several years. Today’s economists learned from the mistakes of the past, and this economic crisis took place in a matter of little more than a week. Perhaps, the rest of the process will also move faster, and the US economy will return to normal productivity in a little time. The best anyone can do is wait and see.